11 12 2015

The coming irrelevance of oil

Independently of the outcome of the Paris Climate Change summit, big oil and coal have started an irreversible decline, facing the competition from renewable energies and an increasing political pressure to de-carbonize our societies. This changes completely the game and eliminates the incentive to reduce supply to get higher prices. In stead, the rush is now to exploit the oil and gas before it is too late. Who comes too late, loses. So OPEC has lost its power for good, and there is no chance it will get it back again.

This is fundamentally changing the international power relations, a process we already can see the beginning of, where wealthy oil-producing countries are facing an uncertain future. And a relentless battle for market shares ensues.

Let us take a look at the main changes that will take place:

1. Coal is king, but also the first loser

This may sound strange as coal is the second most important fuel in the world (30% of all energy consumption in 2012), and also the cheapest. But as it is also the most polluting (45% of CO2 emissions), the first step to de-carbonize is to get off coal. The biggest producer of coal is China (46% of total world production), followed by the US (11%), India (8%) and the European Union (7%). China seems now to be determined to get off coal. The country has an ambitious programme of changing to other energy sources (hydropower, nuclear, natural gas, renewable energy) and coal consumption has already started falling. Who will suffer most are the big coal exporters: Indonesia, Australia, Russia, USA, Colombia and South Africa. And just think about all these nice coal reserves, which will have to stay underground for ever! Their value just evaporated!

2. The cost of producing oil will ultimately decide who will get the market share

Oil is where the battle is just now. Oil prices are now below 40 USD and there is presently an oversupply of oil, as a result of investment decisions taken 5-10 years ago. Oil is expensive to store, and the world storage facilities are almost full, so in the short run oil prices may fall further. But in the longer run they will have to go up again as the oil price ultimately depends on the cost of production of the most expensive producer still on the market. So the short-run game is to see, who will leave the market first or reduce production. In the short run, what matters are not the investments made in the past, but the marginal cost of going on pumping oil, and generally these costs seem to be low, independently of whether it is a high- or low-cost producer. Exceptions are the Canadian oil-sands (high operational costs) and the US shale-oil (continuous drilling is necessary). So these should be the first to suffer. However, it also depends on the financial capacity to hold out in a price-war, as heavily indebted companies (and countries) may be the first to crash.

In the medium run all the high cost producer will lose out: Canadian oil-sands, US shale-oil, Arctic oil and deep-water oil.

Saudi Arabia has been criticised for the ongoing price-war, but their strategy looks quite rational: it has with no comparison the lowest production costs (less than 10 USD a barrel), and it has the financial resources to resist the cost of a prolonged price war. The strategy is to drive out the higher cost producers and make sure it is not Saudi Arabian oil that will have to stay underground forever. Its weakness is that its economy is almost 100% oil-based (exports, tax income). It has refused to cut government expenditure and it has engaged in a costly war in Yemen, so it is currently running a breathtaking public sector deficit (20% of GDP) as the ruling royal family has to maintain the loyalty of the population and at the same time secure the luxurious living standard of its thousands of princes.

Even so, my guess is that Saudi Arabia will stay the course. And if it doesn't, others will. The logic has simply changed. Now the mantra is to get the oil out of the ground as fast as possible and sell it at whatever price it can fetch, as long as it covers production costs. The losers will never be able to sell their oil.

Who will survive this battle in the medium run? As the production costs are top secret, we don't know for sure, but the guess is, among others: Middle East (including Iran), Russia (on-shore), Venezuela, Ecuador, Angola, Nigeria. The losers, among others: US shale oil, Canadian oil sands and deep-water oil production in Norway, UK, Brazil, Russia etc. The Arctic oil projects in Norway, Alaska, Canada, Geenland and Russia are unlikely to take off. Ever. Luckily!

In the long run, all the oil producers will lose, as the world has to de-carbonise.

3. Ultimately, the natural gas producers will also lose, but in the medium term they will win

The drive to de-carbonisation will probably have two stages: one is going from the more polluting to the less polluting fossil fuels, and the other is to move to renewables (and possibly nuclear). These two stages will take place simultaneously, but eventually natural gas will have to be phased out too. Natural gas produces roughly half as much CO2 as coal, so a natural first step is to go from coal to natural gas, a step that China, the US and Europe are taking presently. This shift is a relatively cheap way of halving CO2 emissions, but it implies dependency on the gas providers (which is presently causing much hand-wringing in Europe as the most obvious provider is Russia, so the phasing-out of coal is presently in low gear in the EU). The winners: Russia (benefiting from the Chinese drive to shift from coal to natural gas), Iran, Qatar and US shale gas.

So the conclusion is that the market logic has changed completely. This implies that international power relations are shifting fundamentally. Oil producing countries, which since 1973 have been accustomed to throwing their weight around, are passing (or will pass) from heavyweight to featherweight.

Dedicated oil producing countries in the Middle East, which only know how to pump oil, will retreat into oblivion, as will oil producers as Angola, Nigeria and Venezuela, while more developed oil and coal producing countries as Canada, Australia, Norway, Brazil and Russia will be forced to adapt and diversify their economies. We will take a look at that in our next article.


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Thorbjorn Waagstein

Thorbjørn Waagstein, Economist, PhD, since 1999 working as international Development Consultant in Latin America, Africa and Asia.

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